UNEMPLOYMENT AND ITS NATURAL RATE

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2 IN THIS CHAPTER YOU WILL... Learn about the data used to measure the amount of unemployment Consider how unemployment arises from the process of job search UNEMPLOYMENT AND ITS NATURAL RATE Consider how unemployment can result from minimum-wage laws Losing a job can be the most distressing economic event in a person s life. Most people rely on their labor earnings to maintain their standard of living, and many people get from their work not only income but also a sense of personal accomplishment. A job loss means a lower living standard in the present, anxiety about the future, and reduced self-esteem. It is not surprising, therefore, that politicians campaigning for office often speak about how their proposed policies will help create jobs. In the preceding two chapters we have seen some of the forces that determine the level and growth of a country s standard of living. A country that saves and invests a high fraction of its income, for instance, enjoys more rapid growth in its capital stock and its GDP than a similar country that saves and invests less. An even more obvious determinant of a country s standard of living is the amount of unemployment it typically experiences. People who would like to work but cannot See how unemployment can arise from bargaining between firms and unions Examine how unemployment results when firms choose to pay efficiency wages 579

3 580 PART NINE THE REAL ECONOMY IN THE LONG RUN find a job are not contributing to the economy s production of goods and services. Although some degree of unemployment is inevitable in a complex economy with thousands of firms and millions of workers, the amount of unemployment varies substantially over time and across countries. When a country keeps its workers as fully employed as possible, it achieves a higher level of GDP than it would if it left many of its workers standing idle. This chapter begins our study of unemployment. The problem of unemployment is usefully divided into two categories the long-run problem and the shortrun problem. The economy s natural rate of unemployment refers to the amount of unemployment that the economy normally experiences. Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate, and it is closely associated with the short-run ups and downs of economic activity. Cyclical unemployment has its own explanation, which we defer until we study short-run economic fluctuations later in this book. In this chapter we discuss the determinants of an economy s natural rate of unemployment. As we will see, the designation natural does not imply that this rate of unemployment is desirable. Nor does it imply that it is constant over time or impervious to economic policy. It merely means that this unemployment does not go away on its own even in the long run. We begin the chapter by looking at some of the relevant facts that describe unemployment. In particular, we examine three questions: How does the government measure the economy s rate of unemployment? What problems arise in interpreting the unemployment data? How long are the unemployed typically without work? We then turn to the reasons why economies always experience some unemployment and the ways in which policymakers can help the unemployed. We discuss four explanations for the economy s natural rate of unemployment: job search, minimum-wage laws, unions, and efficiency wages. As we will see, longrun unemployment does not arise from a single problem that has a single solution. Instead, it reflects a variety of related problems. As a result, there is no easy way for policymakers to reduce the economy s natural rate of unemployment and, at the same time, to alleviate the hardships experienced by the unemployed. IDENTIFYING UNEMPLOYMENT We begin this chapter by examining more precisely what the term unemployment means. We consider how the government measures unemployment, what problems arise in interpreting the unemployment data, and how long the typical spell of unemployment lasts. HOW IS UNEMPLOYMENT MEASURED? Measuring unemployment is the job of the Bureau of Labor Statistics (BLS), which is part of the Department of Labor. Every month the BLS produces data on unemployment and on other aspects of the labor market, such as types of employment,

4 CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 581 length of the average workweek, and the duration of unemployment. These data come from a regular survey of about 60,000 households, called the Current Population Survey. Based on the answers to survey questions, the BLS places each adult (aged sixteen and older) in each surveyed household into one of three categories: Employed Unemployed Not in the labor force A person is considered employed if he or she spent most of the previous week working at a paid job. A person is unemployed if he or she is on temporary layoff, is looking for a job, or is waiting for the start date of a new job. A person who fits neither of the first two categories, such as a full-time student, homemaker, or retiree, is not in the labor force. Figure 26-1 shows this breakdown for Once the BLS has placed all the individuals covered by the survey in a category, it computes various statistics to summarize the state of the labor market. The BLS defines the labor force as the sum of the employed and the unemployed: Labor force Number employed number of unemployed labor force the total number of workers, including both the employed and the unemployed Figure 26-1 Adult population (205.2 million) Employed (131.5 million) Labor force (137.7 million) THE BREAKDOWN OF THE POPULATION IN The Bureau of Labor Statistics divides the adult population into three categories: employed, unemployed, and not in the labor force. SOURCE: Bureau of Labor Statistics. Unemployed (6.2 million) Not in labor force (67.5 million)

5 582 PART NINE THE REAL ECONOMY IN THE LONG RUN unemployment rate the percentage of the labor force that is unemployed labor-force participation rate the percentage of the adult population that is in the labor force The BLS defines the unemployment rate as the percentage of the labor force that is unemployed: Number of unemployed Unemployment rate 100. Labor force The BLS computes unemployment rates for the entire adult population and for more narrow groups blacks, whites, men, women, and so on. The BLS uses the same survey to produce data on labor-force participation. The labor-force participation rate measures the percentage of the total adult population of the United States that is in the labor force: Labor force Labor-force participation rate 100. Adult population This statistic tells us the fraction of the population that has chosen to participate in the labor market. The labor-force participation rate, like the unemployment rate, is computed both for the entire adult population and for more narrow groups. To see how these data are computed, consider the figures for In that year, million people were employed, and 6.2 million people were unemployed. The labor force was The unemployment rate was Labor force million. Unemployment rate (6.2/137.7) percent. Because the adult population was million, the labor-force participation rate was Labor-force participation rate (137.7/205.2) percent. natural rate of unemployment the normal rate of unemployment around which the unemployment rate fluctuates Hence, in 1998, two-thirds of the U.S. adult population were participating in the labor market, and 4.5 percent of those labor-market participants were without work. Table 26-1 shows the statistics on unemployment and labor-force participation for various groups within the U.S. population. Three comparisons are most apparent. First, women have lower rates of labor-force participation than men, but once in the labor force, women have similar rates of unemployment. Second, blacks have similar rates of labor-force participation as whites, and they have much higher rates of unemployment. Third, teenagers have lower rates of labor-force participation and much higher rates of unemployment than the overall population. More generally, these data show that labor-market experiences vary widely among groups within the economy. The BLS data on the labor market also allow economists and policymakers to monitor changes in the economy over time. Figure 26-2 shows the unemployment rate in the United States since The figure shows that the economy always has some unemployment and that the amount changes from year to year. The normal rate of unemployment around which the unemployment rate fluctuates is called the natural rate of unemployment, and the deviation of unemployment from its

6 CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 583 UNEMPLOYMENT LABOR-FORCE DEMOGRAPHIC GROUP RATE PARTICIPATION RATE ADULTS (AGES 20 AND OVER) White, male 3.2% 77.2% White, female Black, male Black, female TEENAGERS (AGES 16 19) White, male White, female Black, male Black, female Table 26-1 THE LABOR-MARKET EXPERIENCES OF VARIOUS DEMOGRAPHIC GROUPS. This table shows the unemployment rate and the labor-force participation rate of various groups in the U.S. population for SOURCE: Bureau of Labor Statistics. Percent of Labor Force 10 Unemployment rate Natural rate of unemployment UNEMPLOYMENT RATE SINCE This graph uses annual data on the unemployment rate to show the fraction of the labor force without a job. Figure 26-2 Source: U.S. Department of Labor. natural rate is called cyclical unemployment. In the figure, the natural rate is shown as a horizontal line at 5.5 percent, which is a rough estimate of the natural rate for the U.S. economy during this period. Later in this book we discuss cyclical unemployment the deviation of unemployment from its natural rate

7 584 PART NINE THE REAL ECONOMY IN THE LONG RUN short-run economic fluctuations, including the year-to-year fluctuations in unemployment around its natural rate. In the rest of this chapter, however, we ignore the short-run fluctuations and examine why unemployment is a chronic problem for market economies. CASE STUDY LABOR-FORCE PARTICIPATION OF MEN AND WOMEN IN THE U.S. ECONOMY Women s role in American society has changed dramatically over the past century. Social commentators have pointed to many causes for this change. In part, it is attributable to new technologies such as the washing machine, clothes dryer, refrigerator, freezer, and dishwasher, which have reduced the amount of time required to complete routine household tasks. In part, it is attributable to improved birth control, which has reduced the number of children born to the typical family. And, of course, this change in women s role is also partly attributable to changing political and social attitudes. Together these developments have had a profound impact on society in general and on the economy in particular. Nowhere is that impact more obvious than in data on labor-force participation. Figure 26-3 shows the labor-force participation rates of men and women in the United States since Just after World War II, men and women had very different roles in society. Only 33 percent of women were working or looking for work, in contrast to 87 percent of men. Over the past several decades, the difference between the participation rates of men and women has gradually diminished, as growing numbers of women have entered the labor force and some men have left it. Data for 1998 show that 60 percent of women were in the labor force, in contrast to 75 percent of men. As measured by labor-force participation, men and women are now playing a more equal role in the economy. The increase in women s labor-force participation is easy to understand, but the fall in men s may seem puzzling. There are several reasons for this decline. MORE WOMEN ARE WORKING NOW THAN EVER BEFORE.

8 CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 585 First, young men now stay in school longer than their fathers and grandfathers did. Second, older men now retire earlier and live longer. Third, with more women employed, more fathers now stay at home to raise their children. Fulltime students, retirees, and stay-at-home fathers are all counted as out of the labor force. DOES THE UNEMPLOYMENT RATE MEASURE WHAT WE WANT IT TO? Measuring the amount of unemployment in the economy might seem straightforward. In fact, it is not. Whereas it is easy to distinguish between a person with a full-time job and a person who is not working at all, it is much harder to distinguish between a person who is unemployed and a person who is not in the labor force. Movements into and out of the labor force are, in fact, very common. More than one-third of the unemployed are recent entrants into the labor force. These entrants include young workers looking for their first jobs, such as recent college graduates. They also include, in greater numbers, older workers who had previously left the labor force but have now returned to look for work. Moreover, not all unemployment ends with the job seeker finding a job. Almost half of all spells of unemployment end when the unemployed person leaves the labor force. Because people move into and out of the labor force so often, statistics on unemployment are difficult to interpret. On the one hand, some of those who report being unemployed may not, in fact, be trying hard to find a job. They may be calling themselves unemployed because they want to qualify for a government Labor-Force Participation Rate (in percent) Men Women Figure 26-3 LABOR-FORCE PARTICIPATION RATES FOR MEN AND WOMEN SINCE This figure shows the percentage of adult men and women who are members of the labor force. It shows that over the past several decades, women have entered the labor force, and men have left it. SOURCE: U.S. Department of Labor '98

9 586 PART NINE THE REAL ECONOMY IN THE LONG RUN discouraged workers individuals who would like to work but have given up looking for a job program that financially assists the unemployed or because they are actually working and being paid under the table. It may be more realistic to view these individuals as out of the labor force or, in some cases, employed. On the other hand, some of those who report being out of the labor force may, in fact, want to work. These individuals may have tried to find a job but have given up after an unsuccessful search. Such individuals, called discouraged workers, do not show up in unemployment statistics, even though they are truly workers without jobs. According to most estimates, adding discouraged workers would increase the measured unemployment rate by about one-half of one percentage point. There is no easy way to fix the unemployment rate as reported by the BLS to make it a more reliable indicator of conditions in the labor market. In the end, it is best to view the reported unemployment rate as a useful but imperfect measure of joblessness. HOW LONG ARE THE UNEMPLOYED WITHOUT WORK? In judging how serious the problem of unemployment is, one question to consider is whether unemployment is typically a short-term or long-term condition. If unemployment is short-term, one might conclude that it is not a big problem. Workers may require a few weeks between jobs to find the openings that best suit their tastes and skills. Yet if unemployment is long-term, one might conclude that it is a serious problem. Workers unemployed for many months are more likely to suffer economic and psychological hardship. Because the duration of unemployment can affect our view about how big a problem unemployment is, economists have devoted much energy to studying data on the duration of unemployment spells. In this work, they have uncovered a result that is important, subtle, and seemingly contradictory: Most spells of unemployment are short, and most unemployment observed at any given time is long-term. To see how this statement can be true, consider an example. Suppose that you visited the government s unemployment office every week for a year to survey the unemployed. Each week you find that there are four unemployed workers. Three of these workers are the same individuals for the whole year, while the fourth person changes every week. Based on this experience, would you say that unemployment is typically short-term or long-term? Some simple calculations help answer this question. In this example, you meet a total of 55 unemployed people; 52 of them are unemployed for one week, and three are unemployed for the full year. This means that 52/55, or 95 percent, of unemployment spells end in one week. Thus, most spells of unemployment are short. Yet consider the total amount of unemployment. The three people unemployed for one year (52 weeks) make up a total of 156 weeks of unemployment. Together with the 52 people unemployed for one week, this makes 208 weeks of unemployment. In this example, 156/208, or 75 percent, of unemployment is attributable to those individuals who are unemployed for a full year. Thus, most unemployment observed at any given time is long-term. This subtle conclusion implies that economists and policymakers must be careful when interpreting data on unemployment and when designing policies to help the unemployed. Most people who become unemployed will soon find jobs. Yet most of the economy s unemployment problem is attributable to the relatively few workers who are jobless for long periods of time.

10 CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 587 WHY ARE THERE ALWAYS SOME PEOPLE UNEMPLOYED? We have discussed how the government measures the amount of unemployment, the problems that arise in interpreting unemployment statistics, and the findings of labor economists on the duration of unemployment. You should now have a good idea about what unemployment is. This discussion, however, has not explained why economies experience unemployment. In most markets in the economy, prices adjust to bring quantity supplied and quantity demanded into balance. In an ideal labor market, wages would adjust to balance the quantity of labor supplied and the quantity of labor demanded. This adjustment of wages would ensure that all workers are always fully employed. Of course, reality does not resemble this ideal. There are always some workers without jobs, even when the overall economy is doing well. In other words, the unemployment rate never falls to zero; instead, it fluctuates around the natural rate of unemployment. To understand this natural rate, we now examine the reasons why actual labor markets depart from the ideal of full employment. To preview our conclusions, we will find that there are four ways to explain unemployment in the long run. The first explanation is that it takes time for workers to search for the jobs that are best suited for them. The unemployment that results from the process of matching workers and jobs is sometimes called frictional unemployment, and it is often thought to explain relatively short spells of unemployment. The next three explanations for unemployment suggest that the number of jobs available in some labor markets may be insufficient to give a job to everyone who wants one. This occurs when the quantity of labor supplied exceeds the quantity demanded. Unemployment of this sort is sometimes called structural unemployment, and it is often thought to explain longer spells of unemployment. As we will see, this kind of unemployment results when wages are, for some reason, set above the level that brings supply and demand into equilibrium. We will examine three possible reasons for an above-equilibrium wage: minimum-wage laws, unions, and efficiency wages. frictional unemployment unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills structural unemployment unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one QUICK QUIZ: How is the unemployment rate measured? How might the unemployment rate overstate the amount of joblessness? How might it understate it? JOB SEARCH One reason why economies always experience some unemployment is job search. Job search is the process of matching workers with appropriate jobs. If all workers and all jobs were the same, so that all workers were equally well suited for all jobs, job search would not be a problem. Laid-off workers would quickly find new jobs that were well suited for them. But, in fact, workers differ in their tastes and skills, jobs differ in their attributes, and information about job candidates and job job search the process by which workers find appropriate jobs given their tastes and skills

11 588 PART NINE THE REAL ECONOMY IN THE LONG RUN vacancies is disseminated slowly among the many firms and households in the economy. WHY SOME FRICTIONAL UNEMPLOYMENT IS INEVITABLE Frictional unemployment is often the result of changes in the demand for labor among different firms. When consumers decide that they prefer Compaq over Dell computers, Compaq increases employment, and Dell lays off workers. The former Dell workers must now search for new jobs, and Compaq must decide which new workers to hire for the various jobs that have opened up. The result of this transition is a period of unemployment. Similarly, because different regions of the country produce different goods, employment can rise in one region while it falls in another. Consider, for instance, what happens when the world price of oil falls. Oil-producing firms in Texas respond to the lower price by cutting back on production and employment. At the same time, cheaper gasoline stimulates car sales, so auto-producing firms in Michigan raise production and employment. Changes in the composition of demand among industries or regions are called sectoral shifts. Because it takes time for workers to search for jobs in the new sectors, sectoral shifts temporarily cause unemployment. Frictional unemployment is inevitable simply because the economy is always changing. A century ago, the four industries with the largest employment in the United States were cotton goods, woolen goods, men s clothing, and lumber. Today, the four largest industries are autos, aircraft, communications, and electrical components. As this transition took place, jobs were created in some firms, and jobs were destroyed in others. The end result of this process has been higher productivity and higher living standards. But, along the way, workers in declining industries found themselves out of work and searching for new jobs. Data show that at least 10 percent of U.S. manufacturing jobs are destroyed every year. In addition, more than 3 percent of workers leave their jobs in a typical month, sometimes because they realize that the jobs are not a good match for their tastes and skills. Many of these workers, especially younger ones, find new jobs at higher wages. This churning of the labor force is normal in a well-functioning and dynamic market economy, but the result is some amount of frictional unemployment. PUBLIC POLICY AND JOB SEARCH Even if some frictional unemployment is inevitable, the precise amount is not. The faster information spreads about job openings and worker availability, the more rapidly the economy can match workers and firms. The Internet, for instance, may help facilitate job search and reduce frictional unemployment. In addition, public policy may play a role. If policy can reduce the time it takes unemployed workers to find new jobs, it can reduce the economy s natural rate of unemployment. Government programs try to facilitate job search in various ways. One way is through government-run employment agencies, which give out information about job vacancies. Another way is through public training programs, which aim to ease the transition of workers from declining to growing industries and to help

12 CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 589 disadvantaged groups escape poverty. Advocates of these programs believe that they make the economy operate more efficiently by keeping the labor force more fully employed, and that they reduce the inequities inherent in a constantly changing market economy. Critics of these programs question whether the government should get involved with the process of job search. They argue that it is better to let the private market match workers and jobs. In fact, most job search in our economy takes place without intervention by the government. Newspaper ads, job newsletters, college placement offices, headhunters, and word of mouth all help spread information about job openings and job candidates. Similarly, much worker education is done privately, either through schools or through on-the-job training. These critics contend that the government is no better and most likely worse at disseminating the right information to the right workers and deciding what kinds of worker training would be most valuable. They claim that these decisions are best made privately by workers and employers. UNEMPLOYMENT INSURANCE One government program that increases the amount of frictional unemployment, without intending to do so, is unemployment insurance. This program is designed to offer workers partial protection against job loss. The unemployed who quit their jobs, were fired for cause, or just entered the labor force are not eligible. Benefits are paid only to the unemployed who were laid off because their previous employers no longer needed their skills. Although the terms of the program vary over time and across states, a typical American worker covered by unemployment insurance receives 50 percent of his or her former wages for 26 weeks. While unemployment insurance reduces the hardship of unemployment, it also increases the amount of unemployment. The explanation is based on one of the Ten Principles of Economics in Chapter 1: People respond to incentives. Because unemployment benefits stop when a worker takes a new job, the unemployed devote less effort to job search and are more likely to turn down unattractive job offers. In addition, because unemployment insurance makes unemployment less onerous, workers are less likely to seek guarantees of job security when they negotiate with employers over the terms of employment. Many studies by labor economists have examined the incentive effects of unemployment insurance. One study examined an experiment run by the state of Illinois in When unemployed workers applied to collect unemployment insurance benefits, the state randomly selected some of them and offered each a $500 bonus if they found new jobs within 11 weeks. This group was then compared to a control group not offered the incentive. The average spell of unemployment for the group offered the bonus was 7 percent shorter than the average spell for the control group. This experiment shows that the design of the unemployment insurance system influences the effort that the unemployed devote to job search. Several other studies examined search effort by following a group of workers over time. Unemployment insurance benefits, rather than lasting forever, usually run out after six months or a year. These studies found that when the unemployed become ineligible for benefits, the probability of their finding a new job rises markedly. Thus, receiving unemployment insurance benefits does reduce the search effort of the unemployed. unemployment insurance a government program that partially protects workers incomes when they become unemployed

13 590 PART NINE THE REAL ECONOMY IN THE LONG RUN Even though unemployment insurance reduces search effort and raises unemployment, we should not necessarily conclude that the policy is a bad one. The program does achieve its primary goal of reducing the income uncertainty that workers face. In addition, when workers turn down unattractive job offers, they have the opportunity to look for jobs that better suit their tastes and skills. Some economists have argued that unemployment insurance improves the ability of the economy to match each worker with the most appropriate job. The study of unemployment insurance shows that the unemployment rate is an imperfect measure of a nation s overall level of economic well-being. Most economists agree that eliminating unemployment insurance would reduce the amount of unemployment in the economy. Yet economists disagree on whether economic well-being would be enhanced or diminished by this change in policy. QUICK QUIZ: How would an increase in the world price of oil affect the amount of frictional unemployment? Is this unemployment undesirable? What public policies might affect the amount of unemployment caused by this price change? MINIMUM-WAGE LAWS Having seen how frictional unemployment results from the process of matching workers and jobs, let s now examine how structural unemployment results when the number of jobs is insufficient for the number of workers. To understand structural unemployment, we begin by reviewing how unemployment arises from minimum-wage laws a topic we first analyzed in Chapter 6. Although minimum wages are not the predominant reason for unemployment in our economy, they have an important effect on certain groups with particularly high unemployment rates. Moreover, the analysis of minimum wages is a natural place to start because, as we will see, it can be used to understand some of the other reasons for structural unemployment. Figure 26-4 reviews the basic economics of a minimum wage. When a minimum-wage law forces the wage to remain above the level that balances supply and demand, it raises the quantity of labor supplied and reduces the quantity of labor demanded compared to the equilibrium level. There is a surplus of labor. Because there are more workers willing to work than there are jobs, some workers are unemployed. Because we discussed minimum-wage laws extensively in Chapter 6, we will not discuss them further here. It is, however, important to note why minimumwage laws are not a predominant reason for unemployment: Most workers in the economy have wages well above the legal minimum. Minimum-wage laws are binding most often for the least skilled and least experienced members of the labor force, such as teenagers. It is only among these workers that minimum-wage laws explain the existence of unemployment. Although Figure 26-4 is drawn to show the effects of a minimum-wage law, it also illustrates a more general lesson: If the wage is kept above the equilibrium level for any reason, the result is unemployment. Minimum-wage laws are just one reason why

14 CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 591 Wage Figure 26-4 Minimum wage W E 0 L D Surplus of labor Unemployment L E L S Labor supply Labor demand Quantity of Labor UNEMPLOYMENT FROM A WAGE ABOVE THE EQUILIBRIUM LEVEL. In this labor market, the wage at which supply and demand balance is W E. At this equilibrium wage, the quantity of labor supplied and the quantity of labor demanded both equal L E. By contrast, if the wage is forced to remain above the equilibrium level, perhaps because of a minimum-wage law, the quantity of labor supplied rises to L S, and the quantity of labor demanded falls to L D. The resulting surplus of labor, L S L D, represents unemployment. wages may be too high. In the remaining two sections of this chapter, we consider two other reasons why wages may be kept above the equilibrium level unions and efficiency wages. The basic economics of unemployment in these cases is the same as that shown in Figure 26-4, but these explanations of unemployment can apply to many more of the economy s workers. At this point, however, we should stop and notice that the structural unemployment that arises from an above-equilibrium wage is, in an important sense, different from the frictional unemployment that arises from the process of job search. The need for job search is not due to the failure of wages to balance labor supply and labor demand. When job search is the explanation for unemployment, workers are searching for the jobs that best suit their tastes and skills. By contrast, when the wage is above the equilibrium level, the quantity of labor supplied exceeds the quantity of labor demanded, and workers are unemployed because they are waiting for jobs to open up. QUICK QUIZ: Draw the supply curve and the demand curve for a labor market in which the wage is fixed above the equilibrium level. Show the quantity of labor supplied, the quantity demanded, and the amount of unemployment. UNIONS AND COLLECTIVE BARGAINING A union is a worker association that bargains with employers over wages and working conditions. Whereas only 16 percent of U.S. workers now belong to union a worker association that bargains with employers over wages and working conditions

15 592 PART NINE THE REAL ECONOMY IN THE LONG RUN IN THE NEWS German Unemployment MANY EUROPEAN COUNTRIES HAVE UNemployment insurance that is far more generous than that offered to U.S. workers, and some economists believe that these programs explain the high European unemployment rates. The following article discusses the recent debate over unemployment insurance in Germany. For Germany, Benefits Are Also a Burden BY ELIZABETH NEUFFER BERLIN They grumble and grouse as they wait for their benefit checks at a local unemployment office here about the lack of jobs, about the stupidity of German politicians, about how outrageously high taxes are. What today s unemployed Germans don t complain about is this: the size of their benefit checks. I get unemployment benefits, I make some money working on the black market, I make a living, says Michael Steinbach, a 30-year-old electrician who sports a well-ironed shirt, fashionable glasses, and a briefcase as he waits his turn at the Prenzlauer Berg unemployment office. For now, it s comfortable. Germany s social welfare system takes good care of the jobless, with initial average monthly checks of nearly $900 per month for someone married and the prospect, for those who know how to work the system, of remaining on benefits for life. So blatantly do people abuse this system that Chancellor Helmut Kohl once critically described his country as Leisurepark Germany.... Now partly because... such generous benefits are seriously straining the nation s economy questions are being raised about whether one way to combat unemployment is to reform the social welfare system itself.... Combating unemployment, always a hot topic here, leapt back into public debate last week, after the German Labor office released figures showing that joblessness inched up to 11.7 percent in September, the fifth consecutive postwar record.... The unease here also stems from memories of when Germany last faced such levels of joblessness: 1933, when the unemployed were so desperate they begged in the streets for spare change, relied on soup kitchens for meals, and ushered the Nazis into power. Postwar Germany s reaction was to create a massive welfare state, designed to squelch social unrest through social benevolence. It s more important to have modestly happy people on benefits than poverty and all its side effects such as a high crime rate as in the United States, said Heiner Geissler, a leading figure in the ruling CDU party. It is becoming increasingly clear, though, that preserving benefits has trapped Germany in something of a vicious circle. The nation s high-cost social welfare system is one reason its labor costs are among the highest in the world: Both employees and employers must pay generously into the system, so they need higher wages and profits. More than half of a worker s paycheck goes to taxes. Employer/employee-funded taxes this year alone totaled 52.8 billion deutsche marks, or nearly $30 billion. But high labor costs are a major reason companies are now fleeing for cheaper, neighboring Poland meaning job losses for Germany. At the same time, unemployment benefits have become something of a velvet coffin for the unemployed, discouraging them from taking jobs. Until recently, workers who worked part-time were effectively penalized, as they would receive less unemployment benefits if they were laid off. And generous unemployment benefits mean there is no incentive to take part-time or low-paid work a strategy adopted to fight unemployment in other countries, including the United States.... These benefits are so good that exploiting them is something of a national sport. In a recent, and not uncommon, conversation overheard in a Berlin cafe, a woman bragged about how she was using her Sozialhilfe to pay for a vacation in Italy. Some Germans even register in several districts, knowing it s unlikely they will be caught for receiving multiple benefits. Not surprisingly, more than 60 percent of Germany s unemployed are longterm unemployed. People are used to, and heavily rely on, Father State, said Dieter Hundt, president of the Confederation of Germany Employers Association. We are a bit spoiled by a too tightly woven social net, which doesn t encourage the individual enough to improve his own situation. SOURCE: The Boston Globe, October 12, 1997, p. F1.

16 CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 593 unions, unions played a much larger role in the U.S. labor market in the past. In the 1940s and 1950s, when unions were at their peak, about a third of the U.S. labor force was unionized. Moreover, unions continue to play a large role in many European countries. In Sweden and Denmark, for instance, more than threefourths of workers belong to unions. THE ECONOMICS OF UNIONS A union is a type of cartel. Like any cartel, a union is a group of sellers acting together in the hope of exerting their joint market power. Most workers in the U.S. economy discuss their wages, benefits, and working conditions with their employers as individuals. By contrast, workers in a union do so as a group. The process by which unions and firms agree on the terms of employment is called collective bargaining. When a union bargains with a firm, it asks for higher wages, better benefits, and better working conditions than the firm would offer in the absence of a union. If the union and the firm do not reach agreement, the union can organize a withdrawal of labor from the firm, called a strike. Because a strike reduces production, sales, and profit, a firm facing a strike threat is likely to agree to pay higher wages than it otherwise would. Economists who study the effects of unions typically find that union workers earn about 10 to 20 percent more than similar workers who do not belong to unions. When a union raises the wage above the equilibrium level, it raises the quantity of labor supplied and reduces the quantity of labor demanded, resulting in unemployment. Those workers who remain employed are better off, but those who were previously employed and are now unemployed at the higher wage are worse off. Indeed, unions are often thought to cause conflict between different groups of workers between the insiders who benefit from high union wages and the outsiders who do not get the union jobs. The outsiders can respond to their status in one of two ways. Some of them remain unemployed and wait for the chance to become insiders and earn the high union wage. Others take jobs in firms that are not unionized. Thus, when unions raise wages in one part of the economy, the supply of labor increases in other parts of the economy. This increase in labor supply, in turn, reduces wages in industries that are not unionized. In other words, workers in unions reap the benefit of collective bargaining, while workers not in unions bear some of the cost. The role of unions in the economy depends in part on the laws that govern union organization and collective bargaining. Normally, explicit agreements among members of a cartel are illegal. If firms that sell a common product were to agree to set a high price for that product, the agreement would be a conspiracy in restraint of trade. The government would prosecute these firms in civil and criminal court for violating the antitrust laws. By contrast, unions are exempt from these laws. The policymakers who wrote the antitrust laws believed that workers needed greater market power as they bargained with employers. Indeed, various laws are designed to encourage the formation of unions. In particular, the Wagner Act of 1935 prevents employers from interfering when workers try to organize unions and requires employers to bargain with unions in good faith. The National Labor Relations Board (NLRB) is the government agency that enforces workers right to unionize. collective bargaining the process by which unions and firms agree on the terms of employment strike the organized withdrawal of labor from a firm by a union

17 594 PART NINE THE REAL ECONOMY IN THE LONG RUN Gentlemen, nothing stands in the way of a final accord except that management wants profit maximization and the union wants more moola. Legislation affecting the market power of unions is a perennial topic of political debate. State lawmakers sometimes debate right-to-work laws, which give workers in a unionized firm the right to choose whether to join the union. In the absence of such laws, unions can insist during collective bargaining that firms make union membership a requirement for employment. In recent years, lawmakers in Washington have debated a proposed law that would prevent firms from hiring permanent replacements for workers who are on strike. This law would make strikes more costly for firms and, thereby, would increase the market power of unions. These and similar policy decisions will help determine the future of the union movement. ARE UNIONS GOOD OR BAD FOR THE ECONOMY? Economists disagree about whether unions are good or bad for the economy as a whole. Let s consider both sides of the debate. Critics of unions argue that unions are merely a type of cartel. When unions raise wages above the level that would prevail in competitive markets, they reduce the quantity of labor demanded, cause some workers to be unemployed, and reduce the wages in the rest of the economy. The resulting allocation of labor is, critics argue, both inefficient and inequitable. It is inefficient because high union wages reduce employment in unionized firms below the efficient, competitive level. It is inequitable because some workers benefit at the expense of other workers.

18 CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 595 IN THE NEWS Should You Join a Union? SOMEDAY YOU MAY FACE THE DECISION about whether to vote for or against a union in your workplace. The following article discusses some issues you might consider. On Payday, Union Jobs Stack Up Very Well BY DAVID CAY JOHNSTON With the teamsters success in their two-week strike against United Parcel Service, and with the A.F.L.-C.I.O. training thousands of union organizers in a drive to reverse a quarter-century of declining membership, millions of workers will be asked over the next few years whether they want a union to represent them. It is a complicated question, the answer to which rests on a jumble of determinations: Do you favor collective action or individual initiative? Do you trust the union s leaders? Do you want somebody else speaking for you in dealings with your employer? Do you think you will be dismissed if you sign a union card or that the company will send your job overseas if a union is organized? But in one regard, the choice is simple and it is not the choice that most workers have made during the labor movement s recent decades in the economic wilderness. From a pocketbook perspective, workers are absolutely better off joining a union. Economists across the political spectrum agree. Turning a nonunion job into a union job very likely will have a bigger effect on lifetime finances than all the advice employees will ever read about investing their 401(k) plans, buying a home or otherwise making more of what they earn. Here is how the equation works, said Prof. Richard B. Freeman of Harvard University: For an existing worker in a firm, if you can carry out an organizing drive, it is all to your benefit. If there are going to be losers, they are people who might have gotten a job in the future, the shareholders whose profits will go down, the managers because there will be less profit to distribute to them in pay and, maybe, consumers will pay a little more for the product. But as a worker, it is awfully hard to see why you wouldn t want a union. Overall, union workers are paid about 20 percent more than nonunion workers, and their fringe benefits are typically worth two to four times as much, economists with a wide array of views have found. The financial advantage is even greater for workers with little formal education and training and for women, blacks, and Hispanic workers. Moreover, 85 percent of union members have health insurance, compared with 57 percent of nonunion workers, said Barry Bluestone, a laborfriendly economics professor at the University of Massachusetts. The conclusion draws no argument even from Prof. Leo Troy of Rutgers University, who is widely known in academic circles and among union leaders for his hostility to organized labor. From a standpoint of wages and fringe benefits, Professor Troy said, the answer is yes, you are better off in a union. His objections to unions concern how they reduce profits for owners and distort investment decisions in ways that slow the overall growth of the economy not how they affect workers who bargain collectively. Professor Troy points out that he belongs to a union himself the American Association of University Professors. Donald R. Deere, an economist at the Bush School of Government and Public Service at Texas A & M University, studied the wage differential for comparable union and nonunion workers between 1974 and 1996, a period when union membership fell to 15 percent of American workers from 22 percent. In every educational and age category that he studied, Professor Deere found that union members increased their wage advantage over nonunion workers during those years. Last year, he estimates, unionized workers with less than a high school education earned 22 percent more than their nonunion counterparts. The differential declined as education levels rose, reaching 10 percent for college graduates. It makes sense to belong to a union, Professor Deere said, so long as you don t lose your job in the long term. Source: The New York Times, Money & Business Section, August 31, 1997, p. 1.

19 596 PART NINE THE REAL ECONOMY IN THE LONG RUN Advocates of unions contend that unions are a necessary antidote to the market power of the firms that hire workers. The extreme case of this market power is the company town, where a single firm does most of the hiring in a geographic region. In a company town, if workers do not accept the wages and working conditions that the firm offers, they have little choice but to move or stop working. In the absence of a union, therefore, the firm could use its market power to pay lower wages and offer worse working conditions than would prevail if it had to compete with other firms for the same workers. In this case, a union may balance the firm s market power and protect the workers from being at the mercy of the firm owners. Advocates of unions also claim that unions are important for helping firms respond efficiently to workers concerns. Whenever a worker takes a job, the worker and the firm must agree on many attributes of the job in addition to the wage: hours of work, overtime, vacations, sick leave, health benefits, promotion schedules, job security, and so on. By representing workers views on these issues, unions allow firms to provide the right mix of job attributes. Even if unions have the adverse effect of pushing wages above the equilibrium level and causing unemployment, they have the benefit of helping firms keep a happy and productive workforce. In the end, there is no consensus among economists about whether unions are good or bad for the economy. Like many institutions, their influence is probably beneficial in some circumstances and adverse in others. QUICK QUIZ: How does a union in the auto industry affect wages and employment at General Motors and Ford? How does it affect wages and employment in other industries? THE THEORY OF EFFICIENCY WAGES efficiency wages above-equilibrium wages paid by firms in order to increase worker productivity A fourth reason why economies always experience some unemployment in addition to job search, minimum-wage laws, and unions is suggested by the theory of efficiency wages. According to this theory, firms operate more efficiently if wages are above the equilibrium level. Therefore, it may be profitable for firms to keep wages high even in the presence of a surplus of labor. In some ways, the unemployment that arises from efficiency wages is similar to the unemployment that arises from minimum-wage laws and unions. In all three cases, unemployment is the result of wages above the level that balances the quantity of labor supplied and the quantity of labor demanded. Yet there is also an important difference. Minimum-wage laws and unions prevent firms from lowering wages in the presence of a surplus of workers. Efficiency-wage theory states that such a constraint on firms is unnecessary in many cases because firms may be better off keeping wages above the equilibrium level. Why should firms want to keep wages high? In some ways, this decision seems odd, for wages are a large part of firms costs. Normally, we expect profitmaximizing firms to want to keep costs and therefore wages as low as possible.

20 CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 597 The novel insight of efficiency-wage theory is that paying high wages might be profitable because they might raise the efficiency of a firm s workers. There are several types of efficiency-wage theory. Each type suggests a different explanation for why firms may want to pay high wages. Let s now consider four of these types. WORKER HEALTH The first and simplest type of efficiency-wage theory emphasizes the link between wages and worker health. Better paid workers eat a more nutritious diet, and workers who eat a better diet are healthier and more productive. A firm may find it more profitable to pay high wages and have healthy, productive workers than to pay lower wages and have less healthy, less productive workers. This type of efficiency-wage theory is not relevant for firms in rich countries such as the United States. In these countries, the equilibrium wages for most workers are well above the level needed for an adequate diet. Firms are not concerned that paying equilibrium wages would place their workers health in jeopardy. This type of efficiency-wage theory is more relevant for firms in less developed countries where inadequate nutrition is a more common problem. Unemployment is high in the cities of many poor African countries, for example. In these countries, firms may fear that cutting wages would, in fact, adversely influence their workers health and productivity. In other words, concern over nutrition may explain why firms do not cut wages despite a surplus of labor. WORKER TURNOVER A second type of efficiency-wage theory emphasizes the link between wages and worker turnover. Workers quit jobs for many reasons to take jobs in other firms, to move to other parts of the country, to leave the labor force, and so on. The frequency with which they quit depends on the entire set of incentives they face, including the benefits of leaving and the benefits of staying. The more a firm pays its workers, the less often its workers will choose to leave. Thus, a firm can reduce turnover among its workers by paying them a high wage. Why do firms care about turnover? The reason is that it is costly for firms to hire and train new workers. Moreover, even after they are trained, newly hired workers are not as productive as experienced workers. Firms with higher turnover, therefore, will tend to have higher production costs. Firms may find it profitable to pay wages above the equilibrium level in order to reduce worker turnover. WORKER EFFORT A third type of efficiency-wage theory emphasizes the link between wages and worker effort. In many jobs, workers have some discretion over how hard to work. As a result, firms monitor the efforts of their workers, and workers caught